How to Invest in a Bearish Economy

Stocks are versatile in that you can make money from these investments even when they go down in value. Techniques range from using put options to going short, or doing a short sale of stock.

For traditional investors, the more appropriate strategy is first and foremost to avoid or minimize losses. Making money betting that a stock will fall is closer to speculating than actual investing, so make sure you see the pitfalls and act accordingly.

Consumer discretionary sectors

When the economy is struggling or contracting and people are concerned about their financial situation, some sectors will undoubtedly suffer. If you have money tied up in stocks attached to companies in these sectors, you may suffer as well. In today’s economic environment, you should avoid sectors such as consumer discretionary, which refers to companies that sell products or services that people may want but usually don’t need.

In other words, when consumers (both individuals and organizations) have to make hard choices on tighter budgets, the first areas of spending that will logically shrink are those goods and services that simply aren’t that necessary in people’s daily lives.

Here’s an example: In trying times, those who typically eat at fancy, expensive restaurants will cut back. Maybe they’ll eat at fast food places or simply opt for good ol’ home cooking. Multiply this choice by millions of consumers, and you see that high-end restaurants (and their stocks, if they’re public companies) will see their fortunes sink. Your logic and common sense are very useful here.

The real estate return

Real estate is a major sector, of course, but it has really been licking its wounds in recent years. Real estate may take a few years to truly recover before stock investors can see some obvious opportunities. Cautious investors should wait until the industry shows some consistent traction in terms of housing starts and a strong shrinkage in the national inventory of unsold property.

Are there opportunities for contrarians and speculators? Sure! Of course, the risks are still high, so if you’re talking investing, then having some patience is a better bet for now.

The great credit monster

Too much debt means that someone will get hurt. The unprecedented explosion in debt may have given the economy a huge boost in the late 1990s, but debt now poses great dangers for the rest of this decade.

This massive debt problem is obviously tied to real estate. However, it goes much further. Individuals, companies, and government agencies are carrying too much debt for comfort. It’s not just mortgage debt; it’s also consumer, business, government, and margin debt. The latest addition to this horror show is college debt, which recently surpassed $1 trillion (as of September 2012).

With total debt now in the vicinity of more than $50 trillion, saying that a lot of this debt won’t be repaid is probably a safe bet. Individual and institutional defaults will rock the economy and the financial markets. Bankruptcy is (and will continue to be) a huge issue.

Debt will (and does) weigh heavily on stocks, either directly or indirectly. Because every type of debt is now at record levels, no one is truly immune. Even if a company has no debt whatsoever, it is not immune because consumer debt (credit cards, personal loans, etc.) is at an all-time high. If consumer spending declines, the retailer’s sales go down, its profits shrink, and ultimately, its stock goes down.

Exposure to debt is quite pervasive. Check your 401(k) plan, your bond funds, and your insurance company’s annuity. Banks and mortgage companies issued trillions of dollars’ worth of mortgages in recent years, but after the mortgages were issued, they were sold to other financial institutions. A huge number of mortgages were sold to the most obvious buyers, the Federal National Mortgage Association (FNM) and the Federal Mortgage Assurance Corporation (FRE).

These giant, government-sponsored entities are usually referred to as Fannie Mae and Freddie Mac. They were taken over in 2008 by the federal government because of gross mismanagement and overindebtedness (in the trillions!).

What’s a stock investor to do?

Well, remember that first commandment to avoid or minimize losses? Make sure that you review your portfolio and sell stocks that may get pulverized by the credit monster. That includes many banks and brokerage firms.

Make sure that the companies themselves have no debt, low debt, or at least manageable debt. (Check their financial reports.)

For the venturesome, seek shorting opportunities in those companies most exposed to the dangers of debt.

Cyclical stocks

Another type of stock that you should be cautious about is cyclical stocks. Heavy equipment, automobiles, and technology tend to be cyclical and are very susceptible to downturns in the general economy. Conversely, cyclical stocks do very well when the economy is growing or on an upswing (hence the label).

As individuals and corporations get squeezed with more debt and less disposable income, hard choices need to be made. Ultimately, the result is that people buy fewer big-ticket items. That means that a company selling those items ends up selling less and earning less profit. This loss of profit, in turn, makes that company’s stock go down.

In a struggling, recessionary economy, investing in cyclical stocks is like sunbathing on an anthill and using jam instead of sunblock — not a pretty picture.